4 Tax Benefits You Missed This Year
By now most of us have filed our income tax returns, and the last thing we want to do at this point is think about taxes.
In my opinion, though, the end of tax season is a great time to reflect on our individual tax situation while things are still fresh in our mind with the goal of finding opportunities to save money in the future.
The following are some often overlooked opportunities for putting the tax code to work for you and hopefully pay fewer taxes in the current tax year and beyond.
[Related Article: Should You Pay Your Taxes With a Credit Card?]
1. A Roth IRA
Most folks know that saving in a workplace retirement plan such as a 401k is a great way to shield income from taxes while building up a nest egg for retirement. Many of us forget, however, that these pre-tax savings will someday be taxed as income when we begin making withdrawals in retirement. Ideally, the rates at which these withdrawals are taxed will be lower than the tax bracket we were in when making contributions. This is the ideal arbitrage scenario and is often true for mid-career and senior employees.
Younger workers just starting the climb up the career ladder, however, are typically in a lower tax bracket than they will be later in their careers and in retirement. For these folks, another retirement savings vehicle, the Roth IRA, may be a better option.
While contributions to a Roth are made with after-tax dollars, both these contributions and their earnings can be withdrawn free of income tax in the future. Younger workers can come out ahead by investing in a Roth with after-tax money when in a lower tax bracket in exchange for not paying income taxes in the future on withdrawals when they have entered a higher tax bracket.
One caveat is that if an employer matches 401k contributions, it is a good idea to save enough to qualify for the match before directing after-tax savings to a Roth. The match is in effect a guaranteed return and should not be passed up.
2. Flexible Spending Accounts
Many employers offer their employees a way to set aside a portion of their salary on a pre-tax basis to pay for out-of-pocket medical expenses and for child and dependent care. Given that the IRS does not allow a deduction for medical expenses that do not exceed 7.5% of adjusted gross income (10% for Alternative Minimum Tax purposes), an FSA is usually the only way to save taxes on these expenses. FSAs are particularly valuable for taxpayers who are impacted by the AMT tax because FSA savings allow these taxpayers to shield income from the AMT and offset some of the deductions it disallows, such as the property tax deduction and the state income tax deduction.
[Related Article: The Tax Form That Could Save Your Refund]
3. Proper Asset Location
Having a well diversified portfolio allocated across a variety of asset classes is key to managing the risk and volatility of our investments. It’s equally important to correctly locate these asset classes within the taxable, tax-deferred and tax free parts of our portfolios.
Generally, it is good practice to place less tax-efficient investments such as bonds, whose earnings are taxed as income, in tax-deferred accounts. In contrast, stocks, which are held for long-term appreciation and not income, should be placed in taxable accounts as their earnings will not be taxed until sold. If they’re held for longer than one year, they will be taxed at a maximum rate of 20%, significantly lower than the current top income tax bracket of 39.6%, though higher than the rate in effect in 2012.
4. Performing a Roth Conversion in a Low Income Year
The current weak economy has forced many people out of work and it is taking longer for the unemployed to find a new job. As a result, unemployed workers can experience a significant income decline and drop down one or more tax brackets.
While upsetting and stressful, a significant temporary drop in income opens up the opportunity to convert an IRA to a Roth at a low tax rate and convert taxable income to tax-free income for a relatively low cost. Folks whose income has fallen low enough that their deductions exceed their tax can even perform a partial Roth conversion for no tax at all.
These are just some of the opportunities that taxpayers often overlook. Spending a little time planning for these and similar opportunities early in the tax year can reap large rewards in the form of tax savings and future growth of wealth. So put the tax code to work for you and use it as a tool to help you achieve your long term goals and objectives.
More from Credit.com
